Great Company, Great Stock

Every period in history has glamour companies that capture the attention of the public, media, and investment professionals. These companies are the Microsoft’s, Dells, Coke’s, Disney’s, and Google’s of their time. In each case there future earnings growth is greatly overemphasized and there stock price skyrockets. Everyone knows who these glamour companies are and wants a piece of the action. How could such well run companies with great growth potential ever fail to meet earnings targets?

All the companies mentioned above are great companies in their own right. Each has an outstanding product that everyone knows the name of. However, does a great company make a great stock? Not in the least.

Consider the fact that glamour companies always have excellent growth prospects and usually are trading at extraordinarily high earnings multiples. For instance at the time this article was written Google was trading around $725 with a price to earnings ratio( P/E) of about 50 - 3 times the P/E of the overall market. Essentially the market is saying that Google is expected to increase its earnings 3 times faster than the overall market for the foreseeable future. Should Google ever fail to increase its earnings by 3 times faster than the market then its stock price will plummet.

Just how long can a glamorous growth stock like Google continue to increase its earnings 3 times faster than the overall market? Not that long according to a study published in the winter 1993 Journal of Portfolio Management. The study conducted by Russell Fuller and his colleagues ranked stocks by there P/E ratio and studied there subsequent growth. They found that the stocks in the top fifth of the market in terms of their P/E ratio failed to deliver the growth you would expect. These extremely expensive companies increased their earnings 10% faster than the market in the first year, 3% faster in the second year, 2% faster than the market in years three and four, 1% faster in years 5 and 6, and after that there growth resembled the market.

As soon as the market gets a hint that the growth of a high P/E ratio stock is slowing down the market will literally slaughter it. Every time this happens you will hear stories of people who had their life savings tied up in the company and lost everything. These investors fell for a growth trap and got caught. A great company does not mean the company has a great stock. When purchasing a stock one of the prime indicators of its true price is its price to earnings ratio. A price to earnings ratio much higher than the market is a sign that the stock is overpriced and as such you should stay away.

Please note: We do not recommend purchasing individual stocks. This articles aim was to introduce you to some fallacies of growth investing.